Saturday, January 18, 2020

Amending the Definition of "Accredited Investor"

The definition of an “accredited investor” is the cornerstone of Regulation D that provides a safe harbor exemption for private placements of securities by startups and more mature companies. Only in 2018, $1.7 trillion was invested into the startup sector by means of Regulation D offerings, out of which $228 billion was raised by companies rather than investment funds. Nearly all of the investors in such offerings were accredited. Now, the definition of an accredited investor may be changing to include new categories of people. This will open the extremely risky but yet extremely lucrative startup investment opportunities to more participants.

This blog focuses on certain proposed changes to the definition as it relates to natural persons.

The definition of “accredited investor” came about in 1982 together with the adoption of Regulation D (although the concept of an “accredited person” was first introduced by Rule 242 in 1980). The following categories of natural persons are deemed to be accredited:

  • Any natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
  • Any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1 million (excluding the value of primary residence); and
  • Directors, executive officers, and general partners of the issuer or of the general partner of the issuer.
Other than expanding the income test to include a joint income component in 1988 and excluding the value of one’s primary residence from the net worth calculation as part of the Dodd-Frank Act in 2011, the SEC has not revised the definition since 1982.

On December 18, 2019, the SEC issued proposed rules to amend the accredited investor definition. The rules are currently in the 60-day comment process, so anyone who cares deeply about the outcome is encouraged to submit a comment to the SEC.

The main premise of the proposed rules is the fact that the SEC no longer believes wealth to be a proxy for financial sophistication, and I fully support this conclusion. There should be other criteria for establishing financial sophistication. Hence, the SEC is proposing to add the following new categories of natural persons to the category of accredited investors: (i) those who hold certain professional “certifications, designations or other credentials recognized by the Commission” and (ii) “knowledgeable employees” of a private fund who are investing in that fund. Since I fully agree with adding “knowledgeable employees” to the accredited investor definition list, I will focus my discussion on the persons with professional certifications.

With respect to the professional degrees, the SEC has proposed an initial list of accepted certifications, to be revised and amended from time to time. The initial list includes:
  • A Licensed General Securities Representative (Series 7);
  • A Licensed Investment Adviser Representative (Series 65); and
  • A Licensed Private Securities Offerings Representative (Series 82).
As currently proposed, the list of acceptable professional certifications is narrow and substantially limits eligible persons to those professionals working for broker-dealers (most of whom may already be accredited by other means). These individuals must be sponsored by a FINRA member firm to be allowed to take the Series 7 or 82 exam and first pass an introductory-level Securities Industry Essentials examination. There are no similar requirements for the Series 65 exam. As previously mentioned, taking a Series 7 or 82 exam assumes that such an individual is employed by a FINRA member firm. My view is that those individuals who are not working for a FINRA member firm should also be allowed to take the examinations, and if they pass, become “accredited investors.” In a sense, these exams, if stripped of the sponsorship requirement, should become tests for the minimum expertise necessary to be deemed to be an accredited investor. There should also be annual re-certification to ensure that these individuals keep abreast of all relevant developments in the financial and legal markets. Allowing everyone to take these exams, whether or not affiliated with a FINRA member firm, would render it unnecessary to consider other professional degrees such as a Ph.D. in finance or a Master’s degree in a similar field. All persons, regardless of the professional or educational background, should be able to take the tests and qualify to be an accredited investor. It could make sense, however, to impose investment limitations on those investors who qualify to be accredited solely based on the professional certifications criteria.

Additionally, harmonization of the various definitions that are currently used in different securities laws would go a long way towards simplifying and streamlining the compliance process. Currently, in addition to the definition of an “accredited investor” found in Rule 501(a) of Regulation D under the Securities Act, we have the definition of a “qualified purchaser” under the Investment Company Act of 1940, a “qualified client” under the Investment Advisers Act of 1940, and a “qualified institutional buyer” in Rule 144A under the Securities Act. All of these definitions generally refer to wealthy entities and individuals but vary somewhat with respect to the thresholds and scope.

In conclusion, the proposed rules are a big step forward towards democratizing the definition of “accredited investor.” Having more accredited investors willing and interested to invest in startups will fuel the growth of the startup economy and should result in producing more jobs.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.

Saturday, November 30, 2019

Corporate Formalities for Delaware Startups

You have just formed your very first Delaware corporation. Congratulations! Although as a busy founder you may not have time to take care of ongoing corporate maintenance, there are some minimum corporate formalities that you should strive to maintain.  Below is my list and the reasons why.

One of the main benefits that is afforded by corporate structure is the limited liability protection for its owners. This means that the corporation and its stockholders are treated as separate legal entities. The corporation enters into its own contracts, and therefore, it is only the corporation’s assets, and not the assets of its individual stockholders, that are available to pay for judgments and claims of creditors.

There are, however, circumstances when a creditor of a corporation can “pierce the corporate veil” to hold the corporation’s stockholders liable for the corporation’s debts and other obligations. When deciding whether to pierce the corporate veil and hold stockholders personally liable, courts consider, among other factors, whether:
  • the corporate formalities have been disregarded;
  • the corporation is a mere fa├žade of its owners; 
  • the corporation is inadequately capitalized; 
  • the owners use the corporation’s assets and property as their own; 
  • the corporation makes undocumented “loans” to the owners or extends credit not on market terms; or 
  • the owners simply take money out of the corporation; 
The following best practices with respect to corporate governance and external appearance of the corporation may strengthen the argument that the corporation exists as a separate legal entity:

Stockholder and Board of Directors Meetings. The corporation should hold both annual stockholder and Board meetings (or at least prepare unanimous written consents). In addition, the Board should consider and approve all significant actions of the corporation (such as taking out loans, hiring executive officers, selling securities, entering into any other transaction that is out of the ordinary for such corporation). A majority of disinterested directors or the stockholders should approve all transactions between directors, officers, and the corporation.

Delaware Annual Report and Franchise Tax. In order to maintain good standing in Delaware, the corporation has to file an online annual report with the Delaware Division of Corporations and pay the Delaware franchise tax no later than March 1st of each year.

Delaware Registered Agent. It is important to renew the services of the mandatory Delaware Registered Agent every year.  The fee is about $50/year.

Qualifying to Do Business in the Other States. If the corporation is conducting business in another state, it must register there as a foreign corporation and pay tax on the income derived from that state. The definition of “conducting business” varies state by state. So, please reach out to your accountant or lawyer for assistance with this question.

Separate Bank Account. The corporation must have its own corporate bank account. All expenses must be paid from that account and all revenue be deposited there. If the founders paid for incorporation expenses personally, they should submit an expense report and be reimbursed by the corporation from the corporate bank account. One of the “red flags” for the “piercing of the corporate veil” argument is the co-mingling of funds between the corporation and its owners.

Hiring Employees. The hiring process is complicated and involves setting up payroll, preparing pay notices, registering with appropriate state authorities, complying with federal immigration laws, and obtaining the mandatory insurance policies. Failure to comply with these requirements may result in hefty fines.

Debt Guarantees. Stockholders should be careful not to personally guarantee and pay debts of the corporation (at least not on the recurrent basis). Otherwise, the courts may decide that the owners act as “alter egos” of the corporation and the corporation has lost its separate entity status. Board resolutions should be adopted allowing guarantees for specified purposes only.

Acting on Behalf of the Corporation. All documents signed on behalf of the corporation must indicate the signing officer’s name and title. For example:

XYZ Inc.

Name: John Smith
Title: CEO

Further, all contracts should be in the name of the corporation, and the insurance policies should name the corporation as the insured. The full corporate name should appear on the website, business cards, letterhead, and checks of the corporation. 

In conclusion, although this list seems long, it actually doesn't take much effort to comply with if the proper procedures have already been set up.  Your accounting and legal team should work with you on ensuring that your startup follows all corporate formalities.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Thursday, August 22, 2019

SEC Complaint Against a VC Exempt Reporting Adviser

On August 13, 2019, the SEC filed a complaint against Stuart Frost and Frost Management Company, LLC for violating the antifraud provisions of Sections 206(1)-(2) and 206(4) of the Investment Advisers Act.  This case is a reminder that certain provisions of the Advisers Act apply to all investment fund managers, regardless of whether they are registered, non-registered, or exempt (exempt reporting advisers are referred to as "ERAs").  Also, this case highlights once more the importance of proper disclosure of management fees and expenses (and that they have to be reasonable and market).

Mr. Frost, through his investment management firm, managed five venture capital funds that raised about $63 million.  These funds were invested into start-ups incubated by Frost Data Capital, LLC ("FDC"), an entity wholly-owned by Mr. Frost.  Start-ups paid incubator fees to FDC.  The SEC complaint alleges that these incubator fees were not properly disclosed to the investors and, in fact, were exorbitant.  As stated in the SEC press release, the fees were used to finance Mr. Frost's "extravagant personal expenses" and "lavish lifestyle", and when he ran out of money, he would create and fund new start-ups in order to obtain more incubator fees.

Section 206 of the Advisers Act Applies to All Fund Managers

The anti-fraud provisions of the Advisers Act apply to ALL investment advisers, regardless of their status with the SEC or state authorities, or the absence thereof. In particular, Section 206 of the Advisers Act states:

"It shall be unlawful for any investment adviser by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly—

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client; ...

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative."

Further, all investment advisers owe a fiduciary duty to their clients of undivided loyalty and may not engage in any activity that conflicts with the interests of their clients without their prior consent.  As held by the Supreme Court in SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), the advisers owe to their clients a duty of good faith and full and fair disclosure of all material facts and a duty to avoid misleading them.

According to the complaint, FDC (wholly-owned by Mr. Frost) was financially dependent on the incubator fees paid by portfolio companies.  FDC charged the portfolio companies $21.69 million in incubator fees.  None of that money went to the investors.  In the fund disclosure materials, Frost and his management company either completely omitted the existence of such incubator fees or misled the investors by saying that FDC would charge incubator fees on a case-by-case basis and at below-market rates.  In reality, every portfolio company was charged with such fees, which were $30,000 - $40,000 per month per portfolio company.  The fees had to be paid even if the portfolio company moved out of FDC's offices.  The service contracts could be canceled only upon a 180-day notice, which meant that the startups had to pay for an additional six month period.  Unsurprisingly, these ongoing payments reduced the chance of the startups to succeed, as they were quickly running out of cash.  Overall, there were 24 portfolio companies.  As of 2018, only several remained active.

ERAs Must File with the SEC 

According to Section 202(a)(11) of the Advisers Act, an "investment adviser" is any person that (1) for compensation (2) is engaged in the business of (3) providing advice (4) as to the value of securities or advisability of investing in, purchasing, or selling securities.  The Advisers Act mandates that all investment advisers must register with the SEC, unless exempt or prohibited to do so.  

A fund adviser may be exempt from registering with the SEC if it is an adviser solely to private funds with total AUM under $150 million and that are (i) venture capital funds (Section 203(l) of the Advisers Act) or private funds relying on Section 3(c)(1) or 3(c)(7) exemption under the Investment Company Act (Section 203(m) of the Advisers Act).  Such fund managers must still file Form ADV with the SEC, but a shorter version.

There is also a duty to file annual updates of the Form ADV.  Frost Management Company failed to renew its ERA filing in 2018 and onwards.

In conclusion, this case reminds us that the SEC has jurisdiction over all investment advisers, including the ERAs and the unregistered advisers.  Being an investment adviser, registered or not, big or small, carries the fiduciary duty of good faith and full and fair disclosure that should not be taken lightly.  

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.